Lesson From The Tax Court: Blind Reliance Is Not Reasonable Reliance

The Tax Code’s complexity is legend.  And logarithmic.  The more complex a taxpayer’s financial affairs become, the more difficult it becomes for even reasonable taxpayers to avoid errors.  In recognition of that, almost all of the major penalty statutes allow taxpayers to avoid penalties by showing that they had reasonable cause for errors found on audit.

When complexity hits a certain level, taxpayers turn to professionals for help.  Sometimes taxpayers think doing so absolves them of responsibility for any subsequent errors.  They think that relying on professional help is by itself reasonable.  Today’s case shows why that is not true.

Duane Pankratz v. Commissioner, T. C. Memo. 2021-26 (Mar. 3, 2021) (Judge Holmes), teaches that whether a taxpayer has reasonable cause to avoid penalties depends on much more than simply relying on a CPA to properly prepare the return or identify missing information.  There, the taxpayer engaged in a variety of business activities through 11 corporate entities.  After audit, the IRS proposed to assess over $10 million in deficiencies and penalties.  That’s a lot of error.  The taxpayer claimed to have a reasonable cause for the error: my tax professionals did not tell me.  Why that claim failed provides the main lesson.  Details below the fold. 

Law: The Reasonable Cause Defense In General
To state the obvious, if there is no error, then there is no penalty!  Thus, when the IRS is questioning a return, a taxpayer (or representative) will naturally first try and defend the return by convincing the relevant IRS decision-maker that there was no error.  The relevant decision-maker might be a low level Tax Examiner (who start at GS-4) all the way up to a high level Revenue Agent (who top out at GS-13).  It depends on the complexity of the return and what triggers involvement of an actual IRS employee.

If that first defense does not work, the second line of defense is to avoid penalties by showing that the taxpayer had either a reasonable basis or substantial authority for the position that resulted in the now-conceded error.  §6662(d)(2)(B).  The difference between those two ideas is beyond the scope of this lesson.  But they both go to the idea that the taxpayer took a reasonable stab at dealing with some complexity in applying tax law to the facts, either because the law was complex or opaque law or because the facts were complex or opaque.

If that second line defense does not work, the taxpayer is left with the reasonable cause defense.  This is basically conceding that the error was very clear, and the taxpayer had no basis in law or fact for the position resulting in the error.  Nonetheless, if the taxpayer had a decent excuse for goofing up, no penalty will attach.  The legal term for decent excuse is “reasonable cause.” Specifically, §6664(c)(1) says that no penalty shall be imposed if the taxpayer shows “there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.”

This idea of “reasonable cause” excusing an error pops up in other parts of the Tax Code aside from penalties.  Sometimes when Congress creates very strict substantiation rules for a tax benefit, it permits taxpayers who fail to comply with those rules to still be eligible for the tax benefit if they can show reasonable cause for their non-compliance (and, in addition, if they can also show substantial compliance).

As relevant to today’s lesson, a reasonable cause defense applies to taxpayers who donate property to a charity and claim a resulting deduction of more than $5,000 under §170.  Normally, such taxpayers must obtain a “qualified appraisal of such property” and attach it to the return. §170(f)(11)(C).  Treas. Reg. 1.170A-13(c)(3)(ii) sets out 11 items that an appraisal must include to be a "qualified appraisal."  If the appraisal obtained does not strictly comply with the regulation, the Tax Court will still allow a taxpayer the deduction if the taxpayer at least substantially complied with the purpose of the statute.  See e.g. Emanouil v. Commissioner, T.C. Memo. 2020-120 (in valuation dispute, taxpayer had furnished sufficient information about valuation on return even though not meeting all the 11 requirements in the regulation).

And even if taxpayers do not substantially comply---such as by simply failing to obtain or attach an appraisal—§170(f)(11)(A)(ii)(II) will still allows them to claim the deduction (assuming they properly substantiate the valuation) if they had a good excuse for goofing up---i.e. they had reasonable cause.

Law: Reasonable Reliance as Subset of Reasonable Cause
While the IRS and the courts will consider all the facts and circumstances taxpayers present, the bottom line is that taxpayers must show they acted with ordinary care under those circumstances.

One common circumstance taxpayers present is that the error was caused by their tax professional on whose advice or actions the taxpayer reasonably relied.  Let’s look at that.

Treas. Reg. 1.6664-4(c) gives substantial guidance on how the IRS and courts will evaluate a claimed reliance on a professional’s actions or advice.  For example, one very important factor listed in the regulation is the taxpayer's education, sophistication and business experience.

The Tax Court has structured its evaluation of a reasonable reliance defense into a useful three-part test: (1) was the adviser a competent professional who had sufficient expertise to justify reliance, (2) did the taxpayer give the advisor accurate relevant information, and (3) did the taxpayer actually rely in good faith on the adviser's judgment?  This last test is where the Tax Court takes into account the taxpayer’s education, sophistication, and business experience. Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43 (2000), aff’d 299 F.3d 221 (3rd Cir. 2002).

We see all these tests at work in today’s case, which is a really good lesson in what works and what does not when raising the reasonable reliance defense.

Facts
Dr. Pankratz was a large animal veterinarian entrepreneur.  He made a bundle of money through his business venture of developing, producing, and selling animal vaccines.  In 2002 he sold his vaccine company to Novartis for $85 million.  He then plowed that money into a variety of other business ventures, including many connected with South Dakota tourism, and others connected to ranching.  He organized the tourist ventures into 11 different LLC’s.

The tax years at issue were 2008 and 2009.  During those year Dr. Pankratz paid three different bookkeepers to create the various financial records from these 11 LLCs and all his ranches.

Mr. Peterson handled the books for nine of the LLCs.  Ms. Nash handled the other two.  And Mr. Horning—“one of Pankratz’s longest serving employees”—took care of the ranch operations bookkeeping.  Op. at 6.

Dr. Pankratz has his 2008 and 2009 tax returns prepared by his long-standing accounting firm.  How long-standing?  Well, Judge Holmes tells us it was “the same accounting firm that ha[d] prepared his tax returns since the early 1970’s.”  Op. at 12.  That’s a long time!  The actual employee at the firm who had handled the returns, a CAP named Meier, had only been doing so since 2005.

Mr. Horning was the chief liaison between Dr. Pankratz and Mr. Meier.  In light of the long-standing relationship with Dr. Pankratz, Mr. Horning prepared the initial drafts of the returns, using the firm’s tax software.  Moreover, if Mr. Meier had any questions after reviewing the forms and schedules it was on Mr. Horning to go bother the big boss, if he could be found.

On the 2008 return, Mr. Meier noticed a claimed $2 million deduction for the donation of oil and gas interests to charity.  But there was a big problem: no appraisal was attached to the 2008 return.  Judge Holmes found that neither Mr. Meier nor Mr. Horning told Dr. Pankratz about that problem.  Yet Mr. Meier signed the return and filed it without attaching an appraisal.  “And Pankratz never reviewed his 2008 return before it was filed, because it was filed a day or two before the deadline and he wasn’t around.”  Op. at 17.

The 2009 return had a similar problem, involving the donation of a conference center.  This time, however, Mr. Horning told Pankratz about the problem.  Pankratz suggested just deducting his basis in the donated property and asked Mr. Horning if that would be ok.  Mr. Horning said “sure, boss.”  Neither of them asked Mr. Meier.  The deduction was still for more than $5,000 and there was still no appraisal attached.  Yet again Mr. Meier signed the return.  I confess I do not know why on earth would he do that.  Perhaps some savvy reader can comment?

On audit the IRS disallowed these deductions.  The IRS also disallowed several other deductions: some for depreciation based on a draft cost-segregation study, and some based on bookkeeping errors that were corrected on audit.

The IRS also asserted §6662 substantial understatement penalties.  Sadly for Dr. Pankratz, the IRS apparently complied with the §6751(b) supervisory approval requirements.  Otherwise this would be a different lesson!

Dr. Pankratz timely petitioned the Tax Court where he argued that he should be allowed the charitable deductions because he reasonably relied on his long-time bookkeepers to properly keep the books and on his long-time accounting firm to properly prepare the tax returns.  He made the same argument for why he should not be assessed any §6662 penalty.

For the charitable deductions and associated penalties Judge Holmes rejected the argument.  However, for some of the other deduction errors attributable to bookkeeping errors, Judge Holmes partially accepted the argument.

Lesson 1: Even Long-Time Return Preparer May Not Be Competent Tax Advisor
The first test the Tax Court applies to a reasonable reliance defense is whether the taxpayer’s advisor was competent to give the advised relied upon.

In this case, Dr. Pankratz pointed out that the return preparer who signed the return was a CPA and part of his long-time accounting firm.  Judge Holmes, however, pointed out that the actual communications all went through Mr. Horning.  Mr. Meier never actually gave any advice to Dr. Pankratz to rely upon.  In fact, part of Dr. Pankratz's defense was "hey! no one told me I had to attach an appraisal on the 2008 return!"  And it was Mr. Horning who told him about the missing appraisal on the 2009 return.  So the only tax advice anywhere in the case came from Mr. Horning.

Judge Holmes found that Mr. Horning was not a competent tax advisor.  He had no professional license of any kind and was not in the business of preparing returns for clients.  Instead, he was “just a longtime employee who provides financial-related support to Pankratz and has a bachelor’s degree in accounting.”  Op. at 24.  Such experience “was not enough to make him competent to prepare a large and complex tax return which included information from over a dozen businesses and farms.”  It just made him a long-time return preparer.

Lesson 2: Blind Reliance Is Not Reasonable:  Scope of Duty To Review Return
The Tax Court’s third test to determine a taxpayer’s reasonable reliance is whether the taxpayer relied in good faith on a tax advisor’s judgment.

In this case, Dr. Pankratz argued that he reasonably relied on Mr. Meier’s judgment to file the 2008 return without attaching the required appraisal.  He trusted Meier to do the right thing.

But reliance (unlike love) must not be blind.  Taxpayers have a duty to review a return.  Sometimes that failure can be excused when the error was not one they would be likely to catch.  But in this case,  Dr. Pankratz’s failure to review his 2008 return negated any argument for reasonable cause for two reasons.   First, Judge Holmes finds that Dr. Pankratz was a really smart dude with deep experience running multiple high-dollar businesses.

Second, the error was a big one because Form 8283 says multiple times that you have to attach an appraisal.  That is, it’s not just the statutes and regulations that require attaching a qualified appraisal.  It’s the very form a taxpayer must submit to the IRS.  That Form says plainly that that for “Donated Property Over $5,000....an appraisal is generally required....”  Writes Judge Holmes: “One does not have to be a tax expert to be able to read Form 8283.”  Op. 27.   Judge Holmes emphasizes the point by including a copy of page 2 of the Form in his opinion.

Yet Dr. Pankratz never bothered to even review his returns.  Sure the returns may have been long and complex, but the combo of (1) his smarts and (2) the obviousness of the error meant that his failure to even review the return negated any finding of reasonable cause.  This is very similar to the lesson we saw last week when a sophisticated taxpayer’s failure to notice the omission of $169,000 of income from her return negated her claim to reasonable reliance on her return preparer. See Lesson From The Tax Court: The Incoherence of §6751(b), TaxProf Blog (April 12, 2021).

Lesson 3: Reliance On Bookkeeper Can Be Reasonable Even If Bookkeeper Is Not A Competent Tax Advisor
Some of the §6662 penalty amounts were attributable to items disallowed because of what might be called bookkeeping errors, decisions on how to account for shared expenses among the various business entities.  Judge Holmes uses the same analysis for bookkeepers that he uses for tax advisors, looking to see whether the taxpayer employed competent bookkeepers, provided them access to the relevant information, and reasonable relied upon their services.

Recall that Dr. Pankratz employed three bookkeepers, one of whom was Mr. Horning, the fellow who apparently assured Dr. Pankratz that “sure, we don’t need no stinkin’ appraisal if we just deduct basis!” While Mr. Horning was not a competent tax advisor, Judge Holmes found he was a competent bookkeeper.  So was one of the other two bookkeepers, who was a CPA.  Thus, Judge Holmes ruled that no penalties should apply to the errors attributable to any bookkeeping errors made by those two folks.  But Dr. Pankratz was unable to show why the third bookkeeper was competent.  So Judge Holmes approved penalties associated with errors in those books.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each Monday to TaxProf Blog for yet another Lesson From The Tax Court.